HSBC Holdings plc- Pillar 3 Disclosures - Part 2

Stress testing

Stress testing is an important procedure that is integrated into our market risk management framework to evaluate the potential impact on portfolio values of more extreme, although plausible, events or movements in a set of financial variables. In such scenarios, losses can be greater than those predicted by VaR modelling.

Stress testing is implemented at legal entity, regional and overall Group levels. A set of scenarios is used consistently across all regions within the Group. Scenarios are tailored to capture the relevant events or market movements at each level. The risk appetite around potential stress losses for the Group is set and monitored against referral limits.

Market risk reverse stress tests are undertaken on the premise that there is a fixed loss. The stress testing process identifies which scenarios lead to this loss. The rationale behind the reverse stress test is to understand scenarios that are beyond normal business settings and could have contagion and systemic implications.

Stressed VaR and stress testing, together with reverse stress testing and the management of gap risk, provide management with insights regarding the 'tail risk' beyond VaR, for which HSBC's appetite is limited.

The Market risk stress testing incorporates the historical and hypothetical events.

There are a number of measures which HSBC has permission to use in calculating regulatory capital which are listed in table below. For regulatory purposes, the trading book comprises all positions in CRD financial instruments and commodities which are held with trading intent, which are taken with the intention of benefiting from short-term gains or positions where it can be demonstrated that they hedge positions in the trading book. Trading book positions must either be free of any restrictive covenants on their tradability or be capable of being hedged.

A CRD financial instrument is defined as any contract that gives rise to both a financial asset to one party and a financial liability or equity instrument to another party.

HSBC maintains a trading book policy which defines the minimum requirements for trading book positions and the process for classifying positions as trading or non-trading book. Positions in the trading book are subject to market risk-based rules, i.e. market risk capital, computed using regulatory approved models. Otherwise, the market risk capital is calculated using the Standardised approach.

If any of the policy criteria are not met, then the position is categorised as a non-trading book exposure.

VaR

VaR used for regulatory purposes differs from VaR used for management purposes with key differences listed below. 

The trading books which received approval from the regulator to be covered via an internal model are used to calculate VaR for regulatory purposes. Regulatory VaR levels contribute to the calculation of market risk RWAs.

The regulatory VaR table is based on the regulatory permissions received, plus aggregated sites. This differs from the daily VaR reported in the Annual Report and Accounts which shows a fully diversified view used for internal risk management.

There were no material changes in the VaR used for regulatory purposes and this is in line with expectation.

The decrease in stressed VaR was from the inclusion of new entities which are now consolidated, and with it increased diversification benefits. This approval was under Article 325 permission from the PRA and included Indonesia, Singapore and the Middle East.

The increase in the period end IRC measure was driven from the loss of hedging benefit from short positions as their residual maturity fell below their corresponding liquidity horizons for recognition within the IRC measure.

PVA has decreased by 16% over 2017. PVA movements were driven by: (i) changes of exposure resulting from either new trades/unwinds including the disposal of some ABS legacy exposures, or risk profiles modification due to market movements; (ii) the reduction of observed price dispersion in line with spreads tightening and lower levels of market volatility; (iii) refinements in PVA methodologies reflecting the evolution of market modelling and pricing practices, notably in terms of CVA uncertainty measurement and prudent exit cost of concentrated positions; (iv) the evolution of market infrastructure, notably in terms of market and trade data availability, enabling better price uncertainty measurements; (v) changes in CVA accounting fair value adjustment methodologies which resulted in related additional valuation adjustments; and (vi) position transfer between fair valued and accrued only books.

EVE represents the present value of the future banking book cash flows that could be distributed to equity providers under a managed run-off scenario, i.e. the current book value of equity plus the present value of future net interest income in this scenario. An EVE sensitivity is the extent to which the EVE will change due to a pre-specified movements in interest rates, where all other economic variables are held constant.

Requirements under CRD IV include a capital requirement for operational risk, utilising three levels of sophistication as stated on page 17. We have historically adopted, and currently use, the standardised approach in determining our operational risk capital requirements. Table 45 sets out our operational risk capital requirements by region and global businesses. We use an operational risk model for economic capital calculation purposes.

We recognise that operational risk losses can be incurred for a wide variety of reasons, including rare but extreme events.

The objective of our operational risk management is to manage and control operational risk in a cost-effective manner and within our risk appetite, as defined by GMB.

Responsibility for managing operational risk lies with HSBC's employees. During 2017 we implemented a new operational risk management framework ('ORMF') and Group-wide risk management system. The new ORMF provides an end-to-end view of the non-financial risks, enhancing focus on the risks that matter the most and associated controls. It provides a platform to drive forward-looking risk awareness and assist management focus. It also helps the organisation understand the level of risk it is willing to accept.

Activity to strengthen our risk culture and better embed the use of the new ORMF, particularly the three lines of defence model, was a key focus in 2017.

The first line of defence owns the risk and is responsible for identifying, recording, reporting, managing the risks and ensuring that the right controls and assessments are in place to mitigate these risks. The second line of defence sets the policy and guidelines for managing the risks and provides advice, guidance and challenge to the first line of defence on effective risk management. The third line of defence is Internal Audit which independently ensures we are managing risk effectively.

More details on our ORMF may be found on page 77 of the Annual Report and Accounts 2017.

The Global Operational Risk Committee, which is a sub-committee of the GRMM, meets monthly to discuss key risk issues and review the effective implementation of the ORMF.

Operational risk is organised as a specific risk discipline within Global Risk. The Group Head of Operational Risk is responsible for establishing and maintaining the ORMF, monitoring the level of operational losses and the effectiveness of the internal control environment supported by their second line of defence functions. The Group Head of Operational Risk is accountable to the Group Chief Risk Officer in respect of this element of the overall enterprise-wide, risk management framework.

We have codified our ORMF in a high level standard, supplemented by detailed policies. These policies explain our approach to identifying, assessing, monitoring and controlling operational risk, and give guidance on mitigating actions to be taken when weaknesses are identified.

Monitoring operational risk exposure against risk appetite on a regular basis, and setting out our risk acceptance process, drives risk awareness in a more forward-looking manner. It assists management in determining whether further action is required.

Risk scenario analysis across material legal entities provides a top down, forward-looking assessment of risks to help determine whether they are being effectively managed within our risk appetite or whether further management action is required.

In each of our subsidiaries, business managers are responsible for maintaining an appropriate level of internal control, commensurate with the scale and nature of operations. They are responsible for identifying and assessing risks, designing controls and monitoring the effectiveness of these controls. The ORMF helps managers to fulfil these responsibilities by defining a standard risk assessment methodology and providing a tool for the systematic reporting of operational loss data.

Operational risk and control assessment approach

Operational risk and control assessments are performed by individual business units and functions. The risk and control assessment process is designed to provide business areas and functions with a forward-looking view of operational risks, an assessment of the effectiveness of controls, and a tracking mechanism for action plans so that they can proactively manage operational risks within acceptable levels.

Appropriate means of mitigation and controls are considered. These include:

Recording

We use a Group-wide risk management system to record the results of our operational risk management process. Operational risk and control assessments, as described above, are input and maintained by business units. Business management monitor and follow up the progress of documented action plans.

Operational risk loss reporting

To ensure that operational risk losses are consistently reported and monitored at Group level, all Group companies are required to report individual losses when the net loss is expected to exceed $10,000 and to aggregate all other operational risk losses under $10,000. Losses are entered into the group-wide risk management system and are reported to Governance on a monthly basis.

Details of our accounting policy for AFS equity investments and the valuation of financial instruments may be found on page 192 of the Annual Report and Accounts 2017. A detailed description of the valuation techniques applied to private equity may be found on page 210 of the Annual Report and Accounts 2017.

We operate an integrated bancassurance model that provides insurance products principally for customers with whom we have a banking relationship.

The insurance contracts we sell relate to the underlying needs of our banking customers, which we can identify from our point-of-sale contacts and customer knowledge. The majority of sales are of savings and investment products and term and credit life contracts.

By focusing largely on personal and small- and medium-sized enterprises ('SMEs') lines of business, we are able to optimise volumes and diversify individual insurance risks.

We choose to manufacture these insurance products in HSBC subsidiaries based on an assessment of operational scale and risk appetite. Manufacturing insurance allows us to retain the risks and rewards associated with writing insurance contracts by keeping part of the underwriting profit and investment income within the Group.

We have life insurance manufacturing subsidiaries in nine countries (Argentina, mainland China, France, Hong Kong, Malaysia, Malta, Mexico, Singapore and the UK). We also have a life insurance manufacturing associate in India.

Where we do not have the risk appetite or operational scale to be an effective insurance manufacturer, we engage with a handful of leading external insurance companies in order to provide insurance products to our customers through our banking network and direct channels. These arrangements are generally structured with our exclusive strategic partners and earn the Group a combination of commissions, fees and a share of profits. We distribute insurance products in all of our geographical regions.

Insurance products are sold through all global businesses, but predominantly by RBWM and CMB through our branches and direct channels worldwide.

The risk profile of our insurance manufacturing businesses is measured using an economic capital approach. Assets and liabilities are measured on a market value basis, and a capital requirement is defined to ensure that there is a less than one-in-200 chance of insolvency over a one-year time horizon, given the risks to which the businesses are exposed. The methodology for the economic capital calculation is largely aligned to the pan-European Solvency II insurance capital regulations.

Subsidiaries engaged in insurance activities are excluded from the regulatory consolidation by excluding assets, liabilities and post-acquisition reserves, leaving the investment of these insurance subsidiaries to be recorded at cost and deducted from CET1 subject to thresholds (amounts below the thresholds are risk-weighted).

Further details of the management of financial risks and insurance risk arising from the insurance operations are provided from page 78 of the Annual Report and Accounts 2017.

Strategies and processes in the management of liquidity risk

HSBC has an internal liquidity and funding risk management framework ('LFRF') which aims to allow it to withstand very severe liquidity stresses. It is designed to be adaptable to changing business models, markets and regulations. The management of liquidity and funding is primarily undertaken locally (by country) in our operating entities in compliance with the Group's LFRF, and with practices and limits set by the GMB through the RMM and approved by the Board. Our general policy is that each defined operating entity should be self-sufficient in funding its own activities.

Structure and organisation of the liquidity risk management function 

The Group Treasurer, who reports to the Group Finance Director, has responsibility for the oversight of the LFRF. Asset, Liability and Capital Management ('ALCM') teams are responsible for the application of the LFRF at a local operating entity level.

The elements of the LFRF are underpinned by a robust governance framework, the two major elements of which are:

Group Treasury/Asset, Liability and Capital Management

The Group Treasury team is responsible for setting the Group's policy, proposing risk tolerance and providing review and challenge of the operating entities implementation. Regional and local ALCM teams are responsible for the implementation of group wide and local regulatory policy at a legal entity level.

Balance Sheet Management

Along with the Group's Global Business Lines, the Balance Sheet Management ('BSM') teams form the first line of defence in the management of liquidity risk, ensuring continuous compliance with the firm's risk appetite operating within their risk mandates.

Scope and nature of liquidity risk reporting and measurement

Where possible, the Group maintains standardised platforms utilising common data feeds in order to ensure consistency of standard internal and regulatory reporting and flexibility to deliver ad hoc requests.

Hedging and mitigating liquidity risk at HSBC

Management of liquidity and funding risk

Liquidity coverage ratio

The Liquidity Coverage Ratio ('LCR') aims to ensure that a bank has sufficient unencumbered high-quality liquid assets ('HQLA') to meet its liquidity needs in a 30 calendar day liquidity stress scenario. For the calculation of the LCR, HSBC follows the guidelines set by the European Commission.

The HSBC application of the LCR metric involves the following two key assumptions about the definition of operational deposits and the ability to transfer liquidity from non-EU legal entities:

Net stable funding ratio

HSBC uses the NSFR as a basis for establishing stable funding around the Group. The NSFR requires institutions to maintain sufficient stable funding and reflects a bank's long-term funding profile (funding with a term of more than one year).

Liquid assets of HSBC's principal operating entities

Liquid assets are held and managed on a stand-alone operating entity basis. Most are held directly by each operating entity's BSM department, primarily for the purpose of managing liquidity risk in line with the LFRF.

The liquid asset buffer may also include securities in held-to maturity portfolios. To qualify as part of the liquid asset buffer, held-to-maturity portfolios must have a deep and liquid repo market in the underlying security. Liquid assets also include any unencumbered liquid assets held outside BSM departments for any other purpose. The LFRF gives ultimate control of all unencumbered assets and sources of liquidity to BSM.

Overall adequacy of liquidity risk management at HSBC

All operating entities are required to manage liquidity risk and funding risks on a standalone basis in accordance with the LFRF, which includes the preparation of an Internal Liquidity Adequacy Assessment (ILAA) document, in order to ensure that:

The key objectives of the ILAA process are to:

The final conclusion of the Group ILAAP, approved by the Board of Directors, is that each operating entity:

Analysis of on-balance sheet encumbered and unencumbered assets and off-balance sheet collateral

On-balance sheet encumbered and unencumbered assets

The following table, summarises the total on-balance sheet assets capable of supporting future funding and collateral needs, and shows the extent to which they are currently pledged for this purpose. This disclosure aims to facilitate an understanding of available and unrestricted assets that could be used to support potential future funding and collateral needs.

Under 'Off-balance sheet collateral' below we discuss the off-balance sheet collateral received and re-pledged, and the level of available unencumbered off-balance sheet collateral.

Off-balance sheet collateral

For further details on liquidity and funding risk management, see page 73 onwards of the Annual Report and Accounts 2017.